Nonbusiness Income May Present Opportunities for Taxpayers

When a taxpayer engages in an unusual or infrequent activity, the resulting income may be allocable, instead of apportioned.  When allocating, the income from a transaction may be assigned wholly to one state.  This may present opportunities for tax minimization.  For example, if a taxpayer is based in a low-tax state, but does business in other high-tax states, allocating income to the taxpayer’s home state may reduce its overall state tax liability.  Similarly, if an asset located in a low-tax state, the resulting income may be allocable to the low-tax state.  If the other states in which the taxpayer does business have allocation provisions similar to the state in which the asset was located, tax savings may exist.  Further, taxpayers may take advantage of differences in how states treat business versus nonbusiness income.  In order to understand such opportunities, an analysis of the history of nonbusiness income allocation may prove informative.

Separate accounting was the earliest manifestation of the allocation concept that would later be applied to nonbusiness income.  After the 16th Amendment to the Constitution was ratified in 1913, thereby permitting the federal government to impose an income tax, many states enacted their own income taxes.   Initially, separate accounting for a taxpayer’s business operations was permitted.  However, apportionment methodologies for income tax purposes, which arose from early versions of the unitary concept, as well as apportionment schemes for property taxes, were in place in some states shortly after the 16th Amendment was passed.   For example, in Underwood Typewriter Company v. Chamberlain, 254 U.S. 113 (1920), the Supreme Court wrestled with whether Connecticut could apportion a taxpayer’s net income based upon a property factor.  In this case, the taxpayer utilized separate accounting on a geographical basis (the taxpayer conducted business in New York, Connecticut, and a few other states).  The Court held that apportionment was permitted, as the business operations in one state were inseparable from, and contributed to, operations in other states.  In other words, the taxpayer’s interstate activities constituted a unitary business.

Several other cases have addressed the separate accounting issue over the years.  For example, in Bass, Ratcliff & Gretton, Limited v. State Taxation, 266 U.S. 271 (1924), the Supreme Court held that the taxpayer could not segregate its various business operations through separate accounting in computing its New York franchise tax liability.  The Court found that the taxpayer’s “process of manufacturing [resulted] in no profits until it ends in sales” (i.e., resulted from a unitary chain of operations), and thus New York’s method of apportioning income within and without the state was valid.  The Court noted that separate accounting did not accurately reflect the taxpayer’s business done in the state, as inter-related operations should be considered as a whole.

A plethora of other cases have addressed the same issue, and most have come to the same conclusion regarding separate accounting for a unitary enterprise.

Indeed, separate accounting presents several issues, whereby determining profits from any given state is difficult, if not impossible.  Some of the issues include:

• The relationship of administrative-level overhead to each division or geographical location;
• Transfer pricing between divisions or distinct operations;
• The cost of designing and maintaining a separate accounting system;
• Dividing income from similar or identical operations that are located in more than one state; and
• The contribution of one division or geographic location’s activities to the profitability of the whole enterprise.

In the years that followed, the states enacted a patchwork of apportionment schemes.  In 1957, the Uniform Law Commission (ULC) drafted the Uniform Division of Income for Tax Purposes Act (UDITPA), which set forth a uniform method of apportionment.  Under Congress’ threat of handling the issue of non-uniformity on a federal level, states adopted UDITPA to varying degrees.

In drafting UDITPA, the ULC clearly took unitary principles from earlier Supreme Court decisions into consideration, yet realized that not all income should be subject to apportionment, as there may be streams of income outside of a business’ primary activities.  UDITPA first defined “business income”:

“Business income” means income arising from transactions and activity in the regular course of the taxpayer’s trade or business (transactional test) and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations (functional test).  [Emphasis and notes added]

“Nonbusiness income” was defined as “all income other than business income”.

_____

Carl N. Richie, CPA, is an associate principal in Kaufman Rossin’s Miami office. Kaufman Rossin is one of the top CPA firms in the U.S. Carl can be reached at crichie@kaufmanrossin.com.